Named for the Internal Revenue Code § 1031 in which it appears, like-kind exchanges have been a popular tool for real estate investors since they were first added to the tax code over a century ago.* “1031 exchanges” or like kind exchanges are used to defer taxes due on capital gains from the sale of real property by exchanging real property for other property of like-kind (i.e., other real property).
However, if any portion of the gain from a sale of a relinquished property are not reinvested into a replacement property, then the remaining amount, commonly referred to as boot, is taxable. Boot does not disqualify a 1031 exchange altogether, but rather reduces the amount of the taxable gain which can be deferred. In order to better understand what is and isn’t taxable in a 1031 exchange, we will explore two forms of boot and certain factors that may contribute to them.
Cash Boot
The most common form of boot is cash boot, which refers to instances where an investor fails to reinvest the total proceeds from the sale of a relinquished property when purchasing a replacement property. If, for example, you sold a relinquished property for $700,000 and replaced it with a property purchased at $500,000, you may have a taxable gain up to the $200,000 difference between the equity of your relinquished property and replacement property, depending on the adjusted basis of the relinquished property and allowable closing costs for each transaction. While certain closing costs can paid from sale proceeds on the relinquished property and remain subject to deferral under section 1031, such as legal fees, escrow fees, and brokerage fees, others, such as loan fees and carrying costs, may be considered costs “outside of closing”, the payment of which cannot be deferred for 1031 exchange purposes.
Additionally, when any property which is not of like-kind is included in the exchange transactions along with like-kind property, such as furniture and artwork, then the value of those items may be considered boot.
Mortgage Boot
As part of a process known as trading down, mortgage boot, also known as debt reduction boot, occurs when the debt owed on a replacement property is less than the debt owed on the relinquished property. While you may not directly receive any cash from such an exchange, the funds used to pay off debt is still considered income and is therefore taxable unless exchanged for a debt obligation of equal or greater value. For example, if the mortgage on a relinquished property was $200,000, and the mortgage on the replacement property was $130,000, then the $70,000 difference would be considered mortgage boot.
The foregoing is not intended to be comprehensive nor constitute legal advice. If you would like to discuss your specific circumstances or would like more information, feel free to contact us at (212) 625-8505.
*The first tax deferred like-kind exchange was authorized under Section 202 (c) of the tax code authorized by The Revenue Act of 1921.